Equity Research 16 December 2002AmericasUnited Stat.docx

Equity Research
16 December 2002
Americas/United States
Strategy
Investment Strategy
Assessing the Magnitude and
Sustainability of Value Creation
Illustration by Sente Corporation.
• Sustainable value creation is of prime interest to investors
who seek to
anticipate expectations revisions.
• This report develops a systematic way to explain the factors
behind a
company’s economic moat.
• We cover industry analysis, firm-specific analysis, and firm
interaction.
Investors should assume that CSFB is seeking or will seek
investment banking or other business from the covered
companies.
For important disclosure information regarding the Firm's
ratings system, valuation methods and potential conflicts of

interest,
please visit the website at www.csfb.com/researchdisclosures or
call +1 (877) 291-2683.
research team
Michael J. Mauboussin
212 325 3108
[email protected]
Kristen Bartholdson
212 325 2788
[email protected]
Measuring the Moat 16 December 2002
2
Executive Summary
• Sustainable value creation has two dimensions—how much
economic profit a
company earns and how long it can earn excess returns. Both
are of prime interest to

investors and corporate executives.
• Sustainable value creation is rare. Competitive forces—
including innovation—drive
returns toward the cost of capital. Investors should be careful
about how much they
pay for future value creation.
• Warren Buffett consistently emphasizes that he wants to buy
businesses with
prospects for sustainable value creation. He suggests that
buying a business is like
buying a castle surrounded by a moat—a moat that he wants to
be deep and wide to
fend off all competition. According to Buffett, economic moats
are almost never stable;
competitive forces assure that they’re either getting a little bit
wider or a little bit
narrower every day. This report seeks to develop a systematic
way to explain the
factors that determine a company’s moat.
• Companies and investors use competitive strategy analysis for
two very different
purposes. Companies try to generate returns above the cost of
capital, while investors
try to anticipate revisions in expectations for financial
performance that enable them to

earn returns above their opportunity cost of capital. If a
company’s share price already
captures its prospects for sustainable value creation, investors
should expect to earn
a risk-adjusted market return.
• Studies suggest that industry factors dictate about 10-20% of
the variation of a firm’s
economic profitability, and that firm-specific effects represent
another 20-40%. So a
firm’s strategic positioning has a significant influence on the
long-term level of its
economic profits.
• Industry analysis is the appropriate place to start an
investigation into sustainable
value creation. We recommend getting a lay of the land—
understanding the players, a
review of profit pools, and industry stability—followed by a
five-forces analysis and an
assessment of the likelihood of disruptive technologies.
• A clear understanding of how a company creates shareholder
value is core to
understanding sustainable value creation. We define three broad
sources of added
value: production advantages, consumer advantages, and
external (i.e., government)

advantages.
• How firms interact with one another plays an important role in
shaping sustainable
value creation. We not only consider how companies interact
with their competitors
through game theory, but also how companies can co-evolve as
complementors.
• Brands do not confer competitive advantage in and of
themselves. Brands only add
value if they increase customer willingness to pay or if they
reduce the cost to provide
the good or service.
• We provide a complete checklist of questions to guide the
strategic analysis (see
Appendix A).
3
Introduction
Ideally, corporate managers try to allocate resources so as to
generate attractive long-
term returns on investment. Similarly, investors try to buy the
stocks of companies that

are likely to exceed embedded financial expectations. In both
cases, sustainable value
creation is of prime interest.
What exactly is sustainable value creation? We can think of it
across two dimensions.
First is the magnitude of returns in excess of the cost of capital
that a company can, or
will, generate. Magnitude considers not only the return on
investment but also how
much a company can invest at an above-cost-of-capital rate.
Corporate growth only
creates value when a company generates returns on investment
that exceed the cost of
capital.
The second dimension of sustainable value creation is how long
a company can earn
returns in excess of the cost of capital. This concept is also
known as fade rate,
competitive advantage period (CAP), value growth duration,
and T.
1
Despite the
unquestionable significance of this longevity dimension,
researchers and investors give

it scant attention.
How does sustainable value creation differ from the more
popular sustainable
competitive advantage? A company must have two
characteristics to claim that it has a
competitive advantage. The first is that it must generate, or
have an ability to generate,
returns in excess of the cost of capital. Second, the company
must earn a higher rate of
economic profit than the average of its competitors.
2
As our focus is on sustainable value creation, we want to
understand a company’s
economic performance relative to the cost of capital, not
relative to its competitors
(although these are intimately linked, as we will see). If
sustainable value creation is
rare, then sustainable competitive advantage is even more rare,
given that it requires a
company to perform better than its peers.
We can visualize sustainable value creation by looking at a
company’s competitive life
cycle. (See Exhibit 1.) Companies are generally in one of four
phases (see Appendix B

for a breakdown by industry):
• Innovation. Young companies typically see sharp increases in
return on
investment and significant investment opportunities. This is a
period of rising
returns and heavy investment.
• Fading returns. High returns attract competition, generally
causing economic
returns to gravitate toward the cost of capital. In this phase,
companies still earn
excess returns, but the return trajectory is down, not up.
Investment needs also
moderate.
• Mature. In this phase, the product markets are in competitive
equilibrium. As a
result, companies here earn their cost of capital on average, but
competition
within the industry assures that aggregate returns are no higher.
Investment
needs continue to moderate.
• Subpar. Competitive forces often drive returns below the cost
of capital,
requiring companies to restructure. These companies often
improve returns by
shedding assets, shifting their business model, reducing

investment levels, or
putting themselves up for sale. Alternatively, these companies
can distribute
their assets through a bankruptcy filing.
4
Exhibit 1: A Firm’s Competitive Life Cycle
Increasing Returns
& High Reinvestment
Above-Average
but Fading Returns
Below-Average
Returns
Average
Returns
High Innovation Fading Returns Mature Needs Restructuring
Economic
Return
Discount Rate
(Required

Rate of Return)
Reinvestment
Rates
Increasing Returns
& High Reinvestment
Above-Average
but Fading Returns
Below-Average
Returns
Average
Returns
High Innovation Fading Returns Mature Needs Restructuring
Economic
Return
Discount Rate
(Required
Rate of Return)
Reinvestment
Rates
Source: CSFB estimates.
One of the central themes of this analysis is that competition
drives a company’s return
on investment toward the opportunity cost of capital. This

theme is based on
microeconomic theory and is quite intuitive. It predicts that
companies generating high
economic returns will attract competitors willing to take a
lesser, albeit still attractive,
return which will drive down aggregate industry returns to the
opportunity cost of capital.
Researchers have empirically documented this prediction.
3
To achieve sustainable
value creation, companies must defy the very powerful force of
reversion to the mean.
Recent research on the rate of mean reversion reveals a couple
of important points.
First, the time that an average company can sustain excess
returns is shrinking.
4
This
reduction in sustainable value creation reflects the greater pace
of innovation and a shift
in the composition of public companies (i.e., today there are
more young public
companies than 25 years ago). Second, reinvestment rates and
the variability of
economic returns help explain the rate of fade.

5
For example, a company that generates
high returns while investing heavily signals an attractive
opportunity to both existent and
potential competitors. Success sows the seeds of competition.
Why is sustainable value creation so important for investors? To
start, investors pay for
value creation. Exhibit 2 provides a very simple proxy for how
much value creation
investors have anticipated for the S&P 500 since 1980. We
establish a baseline value
by simply capitalizing the last four quarters of operating net
income for the S&P 500 by
an estimate of the cost of equity capital.
6
We attribute any value above and beyond this
baseline value to future expected value creation. The exhibit
shows that over one-third
of the value of the S&P 500 reflects anticipated value creation,
a ratio that has
increased in recent decades.

5
Exhibit 2: Rolling Four-Quarter Anticipated Value Creation
0%
10%
20%
30%
40%
50%
60%
70%
1
9
8
0
1
9
8
1
1
9
8
2

1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1

9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9

9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
A
n
ti
c
ip
a

te
d
V
a
lu
e
C
re
a
ti
o
n
Source: Standard and Poor’s, Aswath Damodaran, CSFB
estimates.
More significant, sustained value creation is an important
source for potential
expectations revisions. At this point, we must draw a critical
distinction between product
markets—the markets for the goods and services that companies
produce—and capital
markets. Companies seek to understand the industry and
competitive landscape so as
to make decisions and allocate resources in a way that
maximizes long-term economic

profits. In contrast, investors seek to understand whether or not
the expectations
reflected in today’s price are likely to be revised up or down.
So companies and investors both use competitive strategy
analysis, but for two very
different purposes. Companies try to generate returns above the
cost of capital, while
investors try to anticipate revisions in expectations. If a
company’s share price already
captures its prospects for sustainable value creation, investors
should expect to earn a
risk-adjusted market return.
7
We will spend most of our time trying to understand how and
why companies attain
sustainable value creation in product markets. But we should
never lose sight of the fact
that our goal as investors is to anticipate expectations revisions.
Exhibit 3 shows the
process and emphasizes the goal of finding and exploiting
expectations mismatches.

6
Exhibit 3: The Link Between Market Expectations and
Competitive Strategy
Market-Implied
Expectations
for Value Creation
Industry
Analysis
Firm-Specific
Analysis
Potential for
Expectations Revisions
Market-Implied
Expectations
for Value Creation
Industry
Analysis
Firm-Specific

Analysis
Potential for
Expectations Revisions
Source: CSFB.
Over the years, legendary investor Warren Buffett has
consistently emphasized that he
seeks businesses with sustainable competitive advantages. He
often invokes the
metaphor of a moat. He suggests that buying a business is akin
to buying a castle
surrounded by a moat. Buffett wants the economic moat around
the businesses he buys
to be deep and wide to fend off all competition. He goes one
step further, noting that
economic moats are almost never stable; they’re either getting a
little bit wider, or a little
bit narrower, every day. So he sums up his objective as buying a
business where the
economic moat is formidable and widening. Our goal in this
report is to develop a
systematic way to explain the factors behind a company’s moat.

7
What Dictates a Company’s Destiny?
Peter Lynch quips that investors are well advised to buy a
business that's so good that a
dummy can run it, because sooner or later a dummy will run it.
8
Lynch’s comment begs
an important question: What dictates a firm’s economic returns?
Note that we are not
asking what determines a company’s share price performance
(which we know is a
function of expectations revisions), but rather its economic
profitability.
9
Before we answer the question, we can make some empirical
observations. Exhibit 4
shows the spread between cash flow return on investment and
the cost of capital for
over 90 industries in the United States. Our sample includes in
excess of 1,500

companies. We see that some industries have positive economic
return spreads, some
are neutral, and some don’t earn the cost of capital.
Exhibit 4: Industry Returns Vary from Value-Creating to Value-
Destroying
(15.00)
(10.00)
(5.00)
0.00
5.00
10.00
15.00
20.00
R
e
tu
rn
s
m
in
u
s

O
p
p
o
rt
u
n
it
y
C
o
s
t
Source: CSFB HOLT estimates.
Next, we analyze the companies that make up a value-creating
industry (Exhibit 5), a
value-neutral industry (Exhibit 6), and a value-destroying
industry (Exhibit 7). The
important observation is that even the best industries include
value-destroying
companies, while the worst industries have value-creating
companies. That some
companies buck the economics of their industry provides some
insight about potential

sources of economic performance.
8
Exhibit 5: Financial Service Industry—Value Creating
-30
-20
-10
0
10
20
30
40
50
R
e
tu
rn
s
m

in
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Exhibit 6: Telecom Equipment Industry—Value Neutral
(80.0)
(70.0)
(60.0)

(50.0)
(40.0)
(30.0)
(20.0)
(10.0)
0.0
10.0
20.0
R
e
t
u
r
n
s
9

Exhibit 7: Wireless Networking Industry—Value Destroying
-60
-50
-40
-30
-20
-10
0
10
20
R
e
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s
A number of studies suggest that industry effects dictate about
10-20% of the variation
of a firm’s economic profitability, and that firm effects
represent another 20-40%. While
a significant percentage of the variability in economic

profitability remains unexplained,
we see that a firm’s strategy and positioning explain roughly
twice the profit variability as
industry effects do.
10
So while Lynch’s counsel may be wise, the evidence suggests
that finding a company in
a high-return industry or avoiding a company in a low-return
industry is not enough.
Finding a good business requires a thorough understanding of
both industry and firm-
specific circumstances.
A final word before we proceed. Our unit of analysis will be the
firm. In many if not most
cases the proper unit of analysis is the strategic business unit.
This is especially true for
multidivision companies that compete in disparate industries.
That said, the framework
we provide should be sufficiently robust to apply on the
divisional level. So for a
multidivision company, we recommend aggregating the results
after repeating the
analysis for each strategic business unit.

10
Industry Analysis
We start with industry analysis, which we break into three parts:
1. Get the lay of the land. This includes creating an industry
map to understand the
players, constructing profit pools to see whether (and why) the
distribution of
economic profits have changed over time, measuring industry
stability, and
classifying the industry so as to improve alertness to key issues
and opportunities.
2. Assess industry attractiveness through a five-forces analysis.
Of the five forces, we
spend the bulk of our time assessing barriers to entry and
rivalry.
3. Consider the likelihood of disruptive technologies. We
consider the role of
innovation and how and why industries evolve from vertical to
horizontal integration.

The Lay of the Land
A useful way to start competitive analysis is to create an
industry map. A map should
include all the players that might have an impact on a
company’s profitability. The goal
of an industry map is to understand the current and potential
interactions that ultimately
shape the sustainable value creation prospects for the whole
industry as well as the
individual companies within the industry.
From an industry perspective, you can think of three types of
interactions: supplier (how
much it will cost to get inputs), customer (how much someone is
willing to pay for the
good or service), and external (other factors that come into
play, like government
actions). Exhibit 8 shows an illustration for the personal
computer (PC) industry.
11

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Here are some points to bear in mind as you develop an industry
map:
• List firms in order of dominance (typically defined by size).
• Consider potential new entrants as well as existing players.
• Understand the nature of the economic interaction between the
firms

(incentives, payment terms, etc.).
• Evaluate other factors that might influence profitability (e.g.,
labor).
The next step is to construct a historical profit pool.
11
A profit pool shows how the pieces
of an industry’s value-added pie are distributed. The horizontal
axis represents the
percentage of the industry (typically measured in sales) and the
vertical axis measures
economic profitability (cash flow return on investment less the
cost of capital). A review
of profit pools over time is a good way to see value migrations.
Exhibit 9 shows the profit pool for the leading half-dozen U.S.
companies in the PC
industry. Creating a narrative to explain the rise and fall of the
various competitors can
provide important clues about what it takes to generate
sustainable value creation. For
example, the PC profit pool clearly reveals Dell Computer’s
(DELL, $27.43, Outperform,
$32.00) ascendance and Apple’s demise. What changed over the
years to spur that

change in economic position?
13
Exhibit 9: PC Industry Profit Pools, 1991 to 2001
1991
-20
-15
-10
-5
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5
10
15
20
25
30
E

c
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P e rce n t o f in d u stry re ve n u e
HWP CPQ
DELL
AAPL
IBM
1996
-20
-15
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30
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IBMGTW
2001
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14
Another important issue is industry stability. Stable industries,
generally speaking, are
more conducive to sustainable value creation. Unstable
industries, in contrast, present
terrific challenges and opportunities. But the value migration in
unstable industries tends
to be greater than that of stable industries, making sustainable
value creation that much
more elusive.
We can measure industry stability a couple of ways. One simple
but useful proxy is
market-share stability. This analysis looks at the absolute
change in market share for
the companies within the industry over some period. (We
typically use five years.) We
then add up the absolute changes and divide the sum by the
number of competitors.
The lower the average absolute change in the industry, the more
stable the industry is.
Exhibit 10 shows the market-share stability for seven industries.
We see relative stability
in the ready-to-eat cereal, soft drink, and beer markets, while
batteries, personal

computers, and autos demonstrate greater change.
15
Exhibit 10: Market-Share Stability
Ready-to-Eat Cereal 1996 2001 5 Year Change
Kellogg's Co 33.0 32.2 0.8
General Mills 27.0 26.9 0.1
Kraft 16.5 15.7 0.8
Private Label 9.5 11.0 1.5
Quaker Oats Company 9.5 9.6 0.1
Other 4.5 4.6 0.1
Total 100.0 100.0
Average Absolute Change 0.6
Soft Drink 1996 2001 5 Year Change
Coca-Cola 43.1 43.7 0.6
PEPSICO 31.0 31.6 0.6

Cadbury Schweppes 14.6 15.6 1.0
Other 6.6 5.3 1.3
Cott 2.9 3.8 0.9
Royal Crown 1.8 0.0 1.8
Total 100.0 100.0
Beer 1996 2001 5 Year Change
Anheuser-Busch 45.4 48.8 3.4
Miller 21.9 19.3 2.6
Coors 10.0 11.0 1.0
Other 6.8 5.4 1.4
Pabst (includes Stroh) 11.7 5.0 6.7
Heineken 1.6 5.0 3.4
Labatt USA 1.2 2.0 0.8
Gambrinus 0.6 1.8 1.2
Barton 0.8 1.7 0.9
Total 100.0 100.0

Metal Cans 1996 2001 5 Year Change
Ball Corp. 33.0 32.0 1.0
Metal Container Corp. (private) 20.0 22.0 2.0
American National Can 27.0 22.0 5.0
Crown, Cork and Seal 19.0 20.0 1.0
Other 1.0 4.0 3.0
Total 100.0 100.0
Auto 1996 2001 5 Year Change
General Motors 31.3 28.1 3.2
Ford 25.4 21.9 3.5
Other 13.9 19.6 5.7
Chrysler 16.2 13.2 3.0
Toyota 7.7 10.1 2.5
Honda 5.6 7.0 1.5
Total 100.0 100.0
Personal Computer 1996 2001 5 Year Change

Other 42.9 43.9 1.0
HP 14.7 18.0 3.3
Dell 4.3 12.9 8.6
IBM 9.0 6.2 2.8
Fujitsu/ICL 3.7 4.5 0.8
NEC 10.0 3.5 6.5
Gateway 2.7 3.0 0.3
Toshiba 3.9 2.9 1.1
Apple 5.2 2.6 2.6
Acer 3.4 2.5 0.9
Total 100.0 100.0
Battery 1996 2001 5 Year Change
Duracell 38.0 35.7 2.3
Eveready 36.9 31.1 5.8
Rayovac 16.3 19.0 2.7
Others 8.8 14.2 5.4
Total 100.0 100.0

Source: Company data, CSFB analyst estimates.
16
Another proxy for industry stability is pricing trends. Price
changes reflect a host of
factors, including cost structure (fixed versus variable), entry
and exit dynamics,
technological change (e.g., Moore’s Law), and rivalry. All else
being equal, more stable
pricing tends to reflect more stable industries. Exhibit 11 shows
the pricing trends for
about 25 industries, classified as slow-, medium-, and fast-cycle
businesses. Sustaining
value creation in a fast-cycle industry is a challenge.
Exhibit 11: Pricing Stability
Industry Period
Price
Change

(Ann. Avg.)
1987-97
1987-97
1987-97
1987-97
1987-97
1987-97
1987-97
Standard-cycle markets
Paper products
Fresh whole chicken
Beer
Agricultural machinery
Passenger cars
Electric lamps
Household refrigerators
Power tools
Fast-cycle markets

Home electronic equipment
Personal computers
Microwave ovens
Analog integrated circuits
Digital PBXs
Memory chips
Antilock braking systems
Electronic wristwatches (LED/LCD)
Fully suspended bicycles
Early personal computers
Slow-cycle markets
Hospital room per day
College tuition
Funeral expenses
Medical care services
Cable television
Prescription drugs
Movie admissions

1985-95
1987-97
1987-97
1985-95
1987-97
1987-97
1987-97
1987-97
1987-97
1991-95
1982-89
1981-89
1985-89
1991-97
1987-97
1973-83
1992-93
1980-83

+4.1%
+3.8%
+3.7%
+2.5%
+2.2%
+1.9%
+0.7%
+0.7%
+0.5%
-0.4%
-0.7%
-1.2%
-1.5%
-1.9%
-2.2%
-3.5%
-4.3%
-4.6%

-4.8%
-4.9%
-7.0%
-8.6%
-10.0%
-17.0%
-29.9%
Industry Period
Price
Change
(Ann. Avg.)
1987-97
1987-97
1987-97
1987-97
1987-97
1987-97
1987-97
Standard-cycle markets

Paper products
Fresh whole chicken
Beer
Agricultural machinery
Passenger cars
Electric lamps
Household refrigerators
Power tools
Fast-cycle markets
Home electronic equipment
Personal computers
Microwave ovens
Analog integrated circuits
Digital PBXs
Memory chips
Antilock braking systems
Electronic wristwatches (LED/LCD)
Fully suspended bicycles

Early personal computers
Slow-cycle markets
Hospital room per day
College tuition
Funeral expenses
Medical care services
Cable television
Prescription drugs
Movie admissions
1985-95
1987-97
1987-97
1985-95
1987-97
1987-97
1987-97
1987-97
1987-97

1991-95
1982-89
1981-89
1985-89
1991-97
1987-97
1973-83
1992-93
1980-83
+4.1%
+3.8%
+3.7%
+2.5%
+2.2%
+1.9%
+0.7%
+0.7%
+0.5%

-0.4%
-0.7%
-1.2%
-1.5%
-1.9%
-2.2%
-3.5%
-4.3%
-4.6%
-4.8%
-4.9%
-7.0%
-8.6%
-10.0%
-17.0%
-29.9%
Source: Jeffrey R. Williams, Renewable Advantage (New York:
The Free Press, 2000), 11.

Before you turn to an industry analysis using the five-forces
framework, it’s useful to
classify the industry you’re analyzing. The analytical process
remains the same no
matter which class the industry falls into. But the classification
does provide guidance as
to what issues you need to emphasize as you step through the
analysis. For example,
the challenges in a mature industry are likely to be quite
distinct from those in an
emerging industry. Exhibit 12 provides some broad
classifications and the types of
opportunities you can associate with each.
17
Exhibit 12: Industry Structure and Strategic Opportunities
Industry Structure Opportunities
Fragmented industry Consolidation:
- Discover new economies of scale

- Alter ownership structure
Emerging industry First-mover advantages:
- Technological leadership
- Preemption of strategically valuable assets
- Creation of customer switching costs
Mature industry Product refinement
Investment in service quality
Process innovation
Declining industry Leadership strategy
Niche strategy
Harvest strategy
Divestment strategy
International industry Multinational opportunities
Global opportunities
Transnational opportunities
Network industry First-mover advantages
“Winner-takes-all” strategies
Hypercompetitive industry Flexibility

Proactive disruption
Industry Structure Opportunities
Fragmented industry Consolidation:
- Discover new economies of scale
- Alter ownership structure
Emerging industry First-mover advantages:
- Technological leadership
- Preemption of strategically valuable assets
- Creation of customer switching costs
Mature industry Product refinement
Investment in service quality
Process innovation
Declining industry Leadership strategy
Niche strategy
Harvest strategy
Divestment strategy
International industry Multinational opportunities
Global opportunities

Transnational opportunities
Network industry First-mover advantages
“Winner-takes-all” strategies
Hypercompetitive industry Flexibility
Proactive disruption
Source: Jay B. Barney, Gaining and Sustaining Competitive
Advantage (Upper Saddle River, NJ: Prentice-
Hall, Inc., 2002), 110.
Industry Attractiveness—Five-Forces Analysis
Michael Porter’s well-known five-forces framework (see
Exhibit 13) remains one of the
best ways to assess an industry’s attractiveness.
12
Porter argues that the collective
strength of the five forces determines an industry’s potential for
value creation. He
stresses that although this potential varies from industry to
industry, an individual
company’s strategy ultimately dictates the company’s
sustainable value creation.

18
Exhibit 13: Michael Porter’s Five Forces That Shape Industry
Structure
Bargaining power
of suppliers
Threat of
new entrants
Threat of
substitutes
Bargaining power
of buyers
Rivalry Among
Existing FirmsBargaining power
of suppliers
Threat of
new entrants
Threat of

substitutes
Bargaining power
of buyers
Rivalry Among
Existing Firms
Source: Michael E. Porter, Competitive Strategy (New York:
The Free Press, 1980), 4.
While analysts often treat Porter’s five forces with equal
emphasis, we believe that two
of them—threat of entry and rivalry—are so important that they
warrant special, in-depth
treatment. Further, our firm-specific analysis will make a finer
point on some of the other
forces. But for now, here’s a quick look at supplier power,
buyer power, and substitution
threat:
13
• Supplier power is the degree of leverage a supplier has with
its customers in
areas like price, quality, and service. An industry that cannot
pass on to its
customers price increases from its powerful suppliers is
destined to be

unattractive. Suppliers are well positioned if they are more
concentrated than
the industry they sell to, if substitute products do not burden
them, or if their
products have significant switching costs. They are also in a
good position if the
industry they serve represents a relatively small percentage of
their sales
volume, or if the product is critical to the buyer. Sellers of
commodity goods to a
concentrated number of buyers are in a much more difficult
position than sellers
of differentiated products to a diverse buyer base.
• Buyer power is the bargaining strength of the buyers of a
product or service. It is
a function of buyer concentration, switching costs, levels of
information,
substitute products, and the offering’s importance to the buyer.
Informed, large
buyers have much more leverage over their suppliers than do
uninformed,
diffused buyers.

19
• Substitution threat addresses the existence of substitute
products or services,
as well as the likelihood that a potential buyer will switch to a
substitute product.
A business faces a substitution threat if its prices are not
competitive and if
comparable products are available from competitors. Substitute
products limit
the prices that companies can charge, placing a ceiling on
potential returns.
Barriers to entry is arguably the most important of Porter’s five
forces. Before we delve
into the factors that help determine impediments to entry, we
believe it is worthwhile to
review the empirical research on entry and exit.
Timothy Dunne, Mark Roberts, and Larry Samuelson (DRS) did
the most widely cited
study of entry and exit rates.
14
DRS studied in excess of 250,000 U.S. manufacturing
firms over a 20-year span ended in the early 1980s.

A fascinating way to summarize the DRS findings is to imagine
a hypothetical industry in
the year 2002 that has 100 firms with sales of $1 million each.
If the historical patterns
of entry and exit in U.S. industries held true, the following
would be true:
15
• Entry and exit will be pervasive. After five years, between 30
and 40 new firms
will have entered the industry, and will have combined annual
sales of $12-20
million. Half of these entrants will be diversified firms
competing in other
markets, and half new firms. Simultaneously, 30 to 40 firms
with aggregate
sales of $12-20 million will leave the industry. So the industry
will experience a
30-40% turnover in firms, with the entering and exiting firms
representing 12-
20% of the industry’s volume.
• Companies entering and exiting tend to be smaller than the
established firms. A
typical entrant is only about one-third the size of an incumbent,
with the

exception of diversifying firms that build new plants. These
diversifying firms,
which represent less than 10% of total new entrants, tend to be
the same size
as the incumbents.
• Most entrants do not survive ten years, but those that do
thrive. Of the 30 to 40
firms that enter between 2002 and 2007, roughly 60% will exit
by 2012. But the
survivors will nearly double their size by 2012.
• Entry and exit rates vary substantially by industry. DRS
research shows that low
barriers to entry and low barriers to exit tend to go together
You should first review the history of entry and exit in an
industry. If there has been a lot
of entry and exit—suggesting entry and exit barriers are low—
sustainable value
creation will be elusive.
But what influences the entry decision in the first place? On a
broad level, potential
entrants weigh the expected incumbent reactions, the
anticipated payoff size, and the
magnitude of exit costs. We’ll explore each of these in more
detail.
16

Let’s first take a look at the expectations of incumbent reaction
to a potential new entry.
Four specific factors indicate the likely veracity of incumbent
reaction: asset specificity,
the level of the minimum efficient production scale, excess
capacity, and incumbent
reputation.
For a long time, economists thought that a firm’s commitment
to a market was a function
of the amount of assets it had dedicated to the market. More
recently, though,
economists have realized it’s not the amount of assets that
matters, but rather the
20
degree to which those assets are specific to that market. If a
firm’s assets are only
valuable in a specific market, that firm is likely to fight harder
to maintain its position.
A classic illustration is a railroad versus an airline. Say a

company builds a railroad track
from New York to Chicago. That asset can only be used for one
thing: to move a train
back and forth between those two cities. That firm, as a result,
will go to great lengths to
protect its position.
17
Now consider an airline that has a flight from New York to
Chicago.
If that route proves uneconomic for any reason, the airline can
reroute that plane.
Asset specificity can take a number of forms, including site
(assets located next to one
another for efficiency); physical (assets tailored to a specific
transaction); dedicated
(assets that satisfy a particular buyer); and human (workers that
develop skills,
knowledge, or know-how).
18
The next factor is production scale. For many industries,
especially high-fixed-cost
industries, unit costs decline as output rises—to a point. A firm
enjoys economies of

scale when its unit costs decline as the result of its volume
gains. At some point,
however, companies no longer see lower unit costs with
incremental output (constant
returns to scale). The minimum efficient scale of production is
the smallest amount of
volume a company must produce to minimize its unit costs.
The minimum efficient scale of production tells a potential
entrant what market share it
must gain to be able to price its goods competitively. It also
sizes an entrant’s upfront
capital commitment. So when the minimum efficient scale of
production is high relative
to the size of the total market, a potential entrant is looking at
the not-so-enticing
prospects of having to price its products way below its average
cost for some time just
to get to scale. And the steeper the decline in the cost curve, the
less likely the entry.
The main way an entrant can try to offset its production cost
disadvantage is to
differentiate its product, allowing the firm to charge a price
premium versus the rest of
the industry.

Exhibit 14: Minimum Efficient Scale as a Barrier to Entry
C
o
s
t
p
e
r
u
n
it
Average
Cost
Q
Output
Minimum
Efficient
Scale
C
o
s
t
p
e
r

u
n
it
Average
Cost
Q
Output
Minimum
Efficient
Scale
Source: Sharon M. Oster, Modern Competitive Analysis
(Oxford: Oxford University Press, 1999), 62.
21
A third factor in weighing incumbent reaction is excess
capacity. The logic here is quite
straightforward. Assuming that demand remains stable, an
entrant that comes into an
industry with too much capacity increases the excess capacity of
each of the

incumbents. If the industry has economies of scale in
production, the cost of idle
capacity rises. As a result, incumbents work hard to maintain
their market share. So a
new entrant will spur a drop in prices. This prospect deters
entry.
The final factor is incumbent reputation. Firms usually compete
across various markets
over an extended time. As a result, they gain reputations as
being tough—ready to fight
at the least provocation—or as more accommodating. A firm’s
reputation, readily
backed by actions as well as words, can seriously color an
entrant’s decision.
Another important shaper of barriers to entry is the magnitude
of the entrant’s
anticipated payoff. There is no assurance that an entrant will
capture attractive
economic profits if the incumbent has a sufficient advantage.
Incumbent advantages
come in a number of forms, including precommitment contracts,
licenses and patents,
learning curve benefits, and network effects.

The first incumbent advantage is precommitment contracts.
Often, companies secure
important future transactions using long-term contracts. These
contracts are often
efficient and reduce a company’s search costs. An incumbent
with a contract in place is
daunting for a potential entrant.
Precommitment contracts can take a number of forms. One is if
an incumbent has
favorable access to an essential raw material. For example, after
World War II
aluminum producer Alcoa (AA, $23.25, Outperform, $29.40)
signed exclusive contracts
with all of the producers of high-grade bauxite, a key material
in aluminum production.
Potential entrants were deterred by an inability to access
bauxite on the same favorable
terms as Alcoa.
Another form of precommitment contract is a long-term deal
with customers. In the mid-
1980s, there were two producers of the sweetener aspartame,
Monsanto (NutraSweet)
and Holland Sweetener Company. Following the 1987 patent
expiration of aspartame in

Europe, Holland entered that market. The competition did drive
down the price of
aspartame 60%, but Holland lost money. Holland Sweetener had
its eye on the U.S.
market, where patent expiration was set for 1992. But in a
classic precommitment move,
Monsanto signed long-term contracts to supply both Coca-Cola
(KO, $45.87,
Outperform, $57.00) and PepsiCo (PEP, $43.18, Neutral,
$43.00), effectively shutting
Holland out of the U.S.
19
Precommitment can also include quasi-contracts, like a pledge
to always provide a good
or service at the lowest cost. Since new entrants rarely have the
scale to compete with
incumbents, such pledges, if credible, deter entry.
Licenses and patents also shape a potential entrant’s payoff for
common-sense
reasons. A number of industries require a license or
certification from the government to
do business. Acquiring licenses or certifications is costly, hence
creating a barrier for an

entrant.
Patents are also an important entry barrier. But the spirit of a
patent is somewhat
different than that of a license. The intent of a patent is to allow
the innovator to receive
an appropriate return on investment. Most innovations require
substantial upfront costs.
So a free-market system needs a means to compensate
innovators to encourage their
activities. Patents do not discourage innovation, but they do
deter entry for a limited time
into protected activities.
22
Learning curves can also serve as a barrier to entry. The
learning curve refers to an
ability to reduce unit costs as a function of cumulative
experience. Researchers have
studied the learning curve for hundreds of products. The data
show that for the median

firm, a doubling of cumulative output reduces unit costs by
about 20%.
20
A company can
enjoy learning curve benefits without enjoying economies of
scale, and vice versa. But
frequently, the two go hand in hand.
Another important incumbent advantage that can weigh on an
entrant’s payoff is
network effects. Network effects exist when the value of a
product or service increases
as more members use that product. As an example, online
auctioneer eBay (EBAY,
$68.73, Outperform, $80.00) is attractive to the user precisely
because so many buyers
and sellers congregate there. In a particular category, positive
feedback often assures
that one network becomes dominant: eBay has not only
weathered competitive
onslaughts, but has also strengthened its position. These
winner-take-most markets
deter entry.
21

The last point, to reiterate a point from DRS’s analysis of entry
and exit, is that a link
exists between barriers to entry and barriers to exit. High exit
costs discourage entry.
The magnitude of investment an entrant requires and the
specificity of the assets
generally defines exit barriers. Low investment needs and
general assets are consistent
with low barriers to entry.
So how do companies actually deter entry? Robert Smiley
surveyed product managers
about their strategies.
22
While his sample was limited to consumer products companies,
and there may be other biases in the sample, the results are
instructive nonetheless.
(See Exhibit 15.) The first three strategies—learning curve,
advertising, and
R&D/patents—create high entry costs. The last three—
reputation, limit pricing, and
excess capacity—shape judgments of post-entry payoffs.
Virtually all managers
reported use of one or more entry-deterring strategies.

Exhibit 15: Reported Use of Entry-Deterring Strategy
Learning
Curve Advertising
R&D/
Patents Reputation
Limit
Pricing
Excess
Capacity
New Products
Frequently
Occasionally
Seldom
Existing Products
Frequently
Occasionally
Seldom
26%
29

45
62%
16
22
52%
26
21
56%
15
29
31%
16
54
27%
27
47
27%
22

52
8%
19
73
21%
21
58
22%
20
48
21%
17
62
Learning
Curve Advertising
R&D/
Patents Reputation
Limit

Pricing
Excess
Capacity
New Products
Frequently
Occasionally
Seldom
Existing Products
Frequently
Occasionally
Seldom
26%
29
45
62%
16
22
52%
26

21
56%
15
29
31%
16
54
27%
27
47
27%
22
52
8%
19
73
21%
21

58
22%
20
48
21%
17
62
Source: Robert Smiley, “Empirical Evidence on Strategic Entry
Deterrence”, International Journal of Industrial
Organization, Vol. 6, June 1988, 172.
Rivalry among firms addresses how fiercely companies compete
with one another along
dimensions such as price, service, new-product introductions,
and advertising. In almost
all industries, coordination in these areas improves the
collective good. For example, if
competitors coordinate their pricing, their economic returns
benefit.
But there is always a tension between coordinating and
cheating. A firm that cheats
(e.g., lowers its price) in the face of industry coordination
stands to gain

disproportionately. So we can think of rivalry as understanding,
for each firm, the
23
tradeoffs between coordination and cheating. Lots of
coordination suggests low rivalry
and attractive economic returns. Intense rivalry makes it
difficult for firms to generate
high returns.
Coordination is difficult if there are lots of competitors. In this
case, each firm considers
itself a minor player and is more likely to think
individualistically. A concentration ratio is
a common way to measure the number and relative power of
firms in an industry. The
U.S. government calculates concentration ratios as the percent
of value shipments that
the top four companies in an industry represent. Exhibit 16
shows the concentration for
27 industries.

Exhibit 16: Percent of Shipment Value from the Industry’s Four
Largest Companies
Percent of Value of
Shipments Accounted for
Industry Group by the 4 Largest Cos.
Breakfast Cereal 82.9
Confectionary from purchased chocolate 65.2
Aerospace product & parts 62.3
Motor vehicle 49.7
Engine, turbine, & power transmission equipment 42.5
Beverage 40.9
Doll, toy, & game 40.0
Communications equipment 36.5
Meat product 35.0
Semiconductor & other electronic component 34.3
Soap, cleaning compound, & toilet preparation 33.7
Glass & glass product 31.0
Bakeries and tortilla 28.6
Petroleum & coal products 26.0

Navigational, measuring, medical & control instruments 24.1
Computer & electronic product 19.1
Paper 18.5
Apparel 17.6
Medical equipment & supplies 16.3
Electric equipment, appliance, & component 14.8
Textile mills 13.8
Primary metal 13.8
Chemical 11.9
Machinery 11.5
Wood product 10.5
Plastics & rubber products 8.2
Fabricated metal product 3.5
Source: U.S. Census Bureau, Concentration Ratios in
Manufacturing — 1997 Economic Census, June 2001.
Naturally, the flip side suggests that fewer firms lead to more
opportunity for
coordination. To reinforce this point, empirical studies show
that most of the price-fixing

cases that the government prosecutes involve industries with
fewer-than-average
firms.
23
Taking this analysis one step further, it’s not only the number
of firms that matter, but
also the size distribution of those firms. A dominant firm in an
otherwise fragmented
industry may be able to impose discipline on the other firms. In
industries with several
similar-size firms, rivalry tends to be significant.
A widely used measure of industry balance is the Herfindahl-
Hirschman index. The
index is equal to 10,000 times the sum of the square of each
company’s market share.
24
For instance, for an industry with four companies and market
shares of 40%, 30%, 20%,
and 10%, the index would be 3,000. (Take 10,000 x [(.4)
2

+ (.3)
2
+ (.2)
2
+ (.1)
2
].) Many
economists characterize Herfindahl-Hirschman index readings
in excess of 1,800 as
industries with reduced rivalry. Exhibit 17 shows the U.S.-
government calculated index
for 27 industries.
Exhibit 17: Herfindahl-Hirschman Index for Selected Industries
Herfindahl-Hirschman
Index for 50
Industry Group Largest Companies
Motor vehicle 2,505.8
Breakfast Cereal 2,445.9
Aerospace product & parts 1,636.9
Confectionary from purchased chocolate 1,600.6
Engine, turbine, & power transmission equipment 596.2

Beverage 531.5
Doll, toy, & game 495.9
Soap, cleaning compound, & toilet preparation 495.4
Communications equipment 449.0
Semiconductor & other electronic component 413.7
Meat product 392.6
Glass & glass product 359.0
Petroleum & coal products 350.0
Bakeries and tortilla 281.2
Navigational, measuring, medical & control instruments 207.5
Paper 173.3
Medical equipment & supplies 137.5
Computer & electronic product 136.6
Electric equipment, appliance, & component 105.9
Apparel 100.6
Primary metal 97.4
Textile mills 94.4
Chemical 76.6

Machinery 55.4
Wood product 52.7
Plastics & rubber products 30.2
Fabricated metal product 8.5
Source: U.S. Census Bureau, Concentration Ratios in
Manufacturing—1997 Economic Census, June 2001.
Another influence of rivalry is firm homogeneity. If companies
within an industry are
similar—say in incentives, ownership structure, and corporate
philosophy—rivalry may
be less intense. Homogeneity is a particularly important
consideration for global
industries where competing companies often have asymmetric
objectives.
Asset specificity, an issue we addressed in the context of entry
barriers, also plays a
role in rivalry. Specific assets encourage a company to stay in
an industry even under
trying circumstances because the company has no other use for
the assets. In this
context, assets include physical assets like railroad tracks as
well as intangible assets

like brands.
Demand variability, even if it is exogenous, also shapes
coordination costs, and hence
rivalry. When demand variability is high, companies have a
difficult time coordinating
their internal activities and a very difficult time coordinating
with competitors.
25
Variable demand is a particularly important consideration in
industries with high fixed
costs. In these industries, companies often add too much
capacity at points of peak
demand. This capacity, while necessary at the peak, is
massively excessive at the
trough and spurs even more intense competition. The condition
of variable demand and
high fixed costs describes many commodity industries, which is
why their rivalry is so
bitter and consistent excess economic returns are so rare.
A final consideration in rivalry is industry growth. When the pie

of potential excess
economic profits grows, companies can create shareholder value
without undermining
their competitors. The game is not zero-sum. In contrast,
stagnant industries are zero-
sum games, and the only way to increase value is to take it from
others. So a
decelerating industry growth rate is often concomitant with a
rise in rivalry.
Disruption and Disintegration
While the strategy literature has historically been effective at
identifying the
determinants of industry attractiveness, it has been lacking in
its treatment of the
innovation process. In recent years, Clayton Christensen’s
disruptive technology
framework has filled that gap. Christensen’s work exposes a
pattern by which great
companies fail and new innovations take hold. Ironically, he
notes that many companies
fail to retain their leadership positions, even though great
managers are making sound
decisions based on widely accepted management principles.
24

Christensen starts by distinguishing between sustaining and
disruptive technologies.
Sustaining technologies foster product improvement. They can
be incremental,
discontinuous, or even radical. But sustaining technologies
operate within a defined
value network—the “context within which a firm identifies and
responds to customers’
needs, solves problems, procures input, reacts to competitors,
and strives for profit.”
25
In direct contrast, disruptive technologies offer the market a
very different value
proposition. Products based on disruptive technologies may
initially appeal only to
relatively few customers who value features such as low price,
smaller size, or greater
convenience. Furthermore, Christensen finds that these
technologies generally
underperform established products in the near term.
For example, the personal computer disrupted the minicomputer
in the early 1980s. But
a minicomputer user couldn’t switch to a PC, because a PC
wasn’t good enough to

support the necessary applications when it was first launched.
Thus it is not surprising
that leading companies (like Digital Equipment in the case of
the PC) often overlook,
ignore, or dismiss disruptive technologies in the early phases of
the technology.
Technologies often progress faster than the market demands.
(See Exhibit 18.)
Established companies commonly provide customers with more
than they need or more
than they are ultimately willing to pay for. This allows
disruptive technologies to emerge,
because even if they do not meet the demands of users today,
they could become fully
performance-competitive tomorrow.
26
Exhibit 18: Christensen’s Disruptive Technology Framework
Sustaining
Technology

Performance
Disruptive
Technology
Time
Mainstream
Customer
Needs
Meet customer
needs at lower price
Overshoot customer
performance needs
Sustaining
Technology
Performance
Disruptive
Technology
Time
Mainstream

Customer
Needs
Meet customer
needs at lower price
Overshoot customer
performance needs
Source: Clayton M. Christensen, The Innovator’s Dilemma
(Boston: Harvard Business School Press, 1997),
xvi.
Passing over disruptive technologies may appear rational for
established companies,
because disruptive products generally offer low margins,
operate in insignificant or
emerging markets, and are not in demand by the company’s
most profitable customers.
As a result, companies that listen to their customers and
practice conventional financial
discipline are apt to disregard disruptive technologies.
The disruptive technology framework offers other important
insights as well. The first is
that when the performance of a sustaining technology exceeds

the high end of the
consumer’s threshold, it not only allows for the emergence of
disruptive technology, but
also shifts the basis of competition away from performance
toward speed-to-market and
delivery flexibility.
26
So the basis of competition in the more traditional segments of
a
market could change quite significantly. An analysis of the
personal computer industry
reveals that as performance became less important, business
models based on delivery
efficiency became more prominent. Dell was ideally positioned
to take advantage of this
shift.
Another critical insight is that while industries are developing
(i.e., while they are at the
low end of the required performance band), vertically integrated
firms tend to dominate
because of the high coordination costs. Examples include
automobiles and computers.
But as the industry approaches the point where product
performance outstrips

consumer demand, the industry tends to standardize and “dis-
integrate” into horizontal
segments. (See Exhibit 19.) Christensen’s work offers a useful
way to understand and
anticipate when an industry is likely to flip from vertical to
horizontal. Further,
Christensen argues that as the industry migrates from vertical to
horizontal, the value
often migrates to the suppliers.
27
Exhibit 19: Disintegration of the Computer Industry
sales and
distribution
application
software
operating
system

computer
chips
sales and
distribution
application
software
operating
system
computer
chips
IBM DEC Sperry
Univac
Wang
Retail Stores Superstores Dealers Dealers
Word Word Perfect Etc.
DOS and Windows OS/2 Mac UNIX
Compaq Dell Packard Bell
Hewlett –
Packard
IBM Etc.

Intel Architecture Motorola RISCs
The Vertical Computer Industry – Circa 1980 The Horizontal
Computer Industry – Circa 1995
sales and
distribution
application
software
operating
system
computer
chips
sales and
distribution
application
software
operating
system
computer

chips
IBM DEC Sperry
Univac
Wang
Retail Stores Superstores Dealers Dealers
Word Word Perfect Etc.
DOS and Windows OS/2 Mac UNIX
Compaq Dell Packard Bell
Hewlett –
Packard
IBM Etc.
Intel Architecture Motorola RISCs
The Vertical Computer Industry – Circa 1980 The Horizontal
Computer Industry – Circa 1995
Source: Andrew S. Grove, Only the Paranoid Survive (New
York: Doubleday, 1999), 44.
An industry profit pool is a good way to see value migrations as
the result of industry
disintegration. Take another look at Exhibit 9. Apple
Computer’s (AAPL, $15.19,
Neutral, $18.00) share of the PC industry’s profit pool
evaporated over the past dozen

years, while Dell Computer’s has grown. We can translate this
framework directly into
the economic profit pools of the industry.
Industry analysis provides important background for
understanding a company’s current
or potential performance. But as we noted earlier, firm specific
factors explain twice as
much of the variation in economic returns as industry factors
do. So we now turn to
analyzing the firm.
28
Firm-Specific Analysis
Core to understanding sustainable value creation is a clear
understanding of how a
company creates shareholder value. A company’s ability to
create value is a function of
the strategies it pursues, as well as how it chooses to interact
with competitors and
important noncompetitors.

We first provide a fundamental framework for value creation.
We then consider the
various ways a company can add value. Finally, we delve into
firm interaction using
game theory and principles of co-evolution.
A Framework for Added-Value Analysis
Adam Brandenburger and Harbourne Stuart offer a very
concrete and sound definition
of how a firm adds value.
27
Their equation is deceptively simple:
Value created = willingness-to-pay of the buyer – opportunity
cost of the supplier
The equation basically says that the value a company creates is
the difference between
what it gets for its product or service and what it costs to
produce that product (including
the opportunity cost of capital). The key to the equation is
thinking through what the
terms mean.
Let’s start with willingness to pay. Imagine that someone
handed you a brand new
tennis racket. Clearly, that would be good for you. Now imagine

that the same person
started withdrawing money from you bank account, starting
with small sums. The
amount of money at which you are indifferent to having the
racket or having the cash is
the definition of willingness to pay.
The flip side describes opportunity cost. A firm takes some
resources away from its
supplier. Opportunity cost is the cash amount that makes the
supplier perceive the new
situation (cash) as equivalent to the old situation (resources).
Brandenburger and Stuart then go on to define four simple
strategies to create more
value: increase the willingness to pay of your customers; reduce
the willingness to pay
of your competitors; reduce the opportunity cost of your
suppliers; and increase the
opportunity cost of suppliers to your competitors. This
framework also fits well with
Porter’s generic strategies to achieve competitive advantage—
low-cost producer
(production advantage) and differentiation (consumer
advantage).

Brandenburger teamed up with colleague Barry Nalebuff to
create what they call a
“value net.”
28
We present the value net slightly differently than the authors
do, but the
components and configuration are identical. (See Exhibit 20.)
On the left are the firm’s
suppliers. On the right are the firm’s customers. Between the
suppliers and customers
are the company, its competitors, and its complementors—a
term we will define in much
more detail below. For now, the point is that companies beyond
a firm’s suppliers,
customers, and competitors can affect the amount of added
value that it can capture.
29
Exhibit 20: Added-Value Analysis—The Value Net
Competitors
Complementors

CompanySuppliers Customers
Competitors
Complementors
CompanySuppliers Customers
Source: Adapted from Adam M. Brandenburger and Barry J.
Nalebuff, Co-opetition (New York: Doubleday,
1996), 17.
The value net fits comfortably into Michael Porter’s traditional
five-forces and value-
chain analysis, but adds an important element: Strategy is not
only about risk and
downside, it’s also about opportunity and upside. Industrial
organization economics has
historically stressed non-cooperative game theory, a reasonable
framework in well-
established industries near product price equilibrium. In
contrast, cooperative game
theory recognizes that many industries are more dynamic and
offer opportunities to
cooperate as well as to compete.
Sources of Added Value
We can define three broad sources for added value: production

advantages, consumer
advantages, and external (i.e., government) issues. Note that
there is substantial
overlap between this analysis and the industry analysis, but here
we are zooming in on
the firm.
Firms with production advantages create value by delivering
products that have a larger
spread between perceived consumer benefit and cost than their
competitors, primarily
by outperforming them on the cost side. We distill production
advantages into two parts:
process and scale economies.
Here are some issues to think through to determine whether or
not a firm has a process
advantage:
• Indivisibility. Economies of scale are particularly important in
high-fixed-cost
businesses. Fixed costs are associated with indivisibility in the
production
process. Indivisibility means that a company can’t scale down
its production
costs beyond a minimum level even if output is low. Bakery
distribution routes

are an example. If a bakery wants to service a region, it must
have a bakery,
trucks, and drivers. These parts are indivisible, and a firm must
bear their cost
no matter what bread demand looks like. At the same time, if
the trucks go from
half to completely full, fixed costs don’t change much.
30
• Complexity. Simple processes are easy to imitate and are
unlikely to be a
source of advantage. More complex processes, in contrast,
require more know-
how or coordination capabilities and can be a source of
advantage. For
example, Gillette spent over $200 million to develop the Sensor
shaving system.
Most of the spending went to technology breakthroughs, and the
company
earned 29 patents to protect the process.
• Rate of change in process cost. For some industries, the

production costs
decline over time as a result of technological advances. For
example, the
process-related cost of building a distribution company today is
less than in the
past because of technology, but the cost in the future is likely to
be lower than
today for the same reason. For industries with declining process
costs, the
incumbent has learning curve advantages while the challenger
has the
advantage of potentially lower future cost. So the analysis must
focus on the
trade-off between learning advantages and future cost
advantages.
• Protection. Look for patents, copyrights, trademarks, and
operating rights that
protect a firm’s process. Research suggests that patent-protected
products as a
group generated higher economic returns than any single
industry.
29
• Resource uniqueness. The example of Alcoa’s bauxite contract
is a good
illustration of access to a unique resource.

Economies of scale are the second category of potential
production advantage. We start
by noting that economies of scale are hard to achieve, and the
bigger the domain, the
harder it is. For example, global economies of scale are
significantly more difficult to
attain than regional economies of scale.
McKinsey analysis suggests that currently about one-third of all
industries are global,
one-third are national, and one-third are regional. (See Exhibit
21.) Their analysis also
suggests that industries are becoming increasingly global over
time. Since global scale
economies are hard to achieve the implication is that sustainable
value creation is, and
will continue to be, hard to achieve as well.
31
Exhibit 21: Various Industries and Their Stages of
Globalization
Industry

Physical commodities
Scale-driven business
goods and services
Manufactured
commodities
Labor skill/productivity-driven
consumer goods
Brandable, largely regulated
consumer goods
Professional business services
Historically highly regulated
(nationally) industries
High interaction cost consumer
goods and services
Locally regulated or high trans-
portation cost goods and services
Government services
Petroleum, mineral ores, timber

Aircraft engines, construction equipment, semiconductors,
airframes, shipping, refineries, machine tools, telecom
equipment
Refined petroleum products, aluminum, specialty steel, bulk
pharmaceuticals, pulp, specialty chemicals
Consumer electronics, personal computers, cameras,
automobiles,
televisions
Beer, shoes, luxury goods, pharmaceuticals, movie production
Investment banking, legal services, accounting services,
consulting
services
Personal financial services, telecommunications service
providers,
electric power service providers
Food, television production, retail distribution, funeral homes,
small business services
Construction materials, real property, education, household
services, medical care
Civil servants, national defense

Examples
1
2
3
4
5
6
7
8
9
10
GLOBAL
LOCAL
~33%
Globally
defined
~33%
Nationally

defined
~33%
Locally
defined
Industry
Physical commodities
Scale-driven business
goods and services
Manufactured
commodities
Labor skill/productivity-driven
consumer goods
Brandable, largely regulated
consumer goods
Professional business services
Historically highly regulated
(nationally) industries
High interaction cost consumer

goods and services
Locally regulated or high trans-
portation cost goods and services
Government services
Petroleum, mineral ores, timber
Aircraft engines, construction equipment, semiconductors,
airframes, shipping, refineries, machine tools, telecom
equipment
Refined petroleum products, aluminum, specialty steel, bulk
pharmaceuticals, pulp, specialty chemicals
Consumer electronics, personal computers, cameras,
automobiles,
televisions
Beer, shoes, luxury goods, pharmaceuticals, movie production
Investment banking, legal services, accounting services,
consulting
services
Personal financial services, telecommunications service
providers,
electric power service providers

Food, television production, retail distribution, funeral homes,
small business services
Construction materials, real property, education, household
services, medical care
Civil servants, national defense
Examples
1
2
3
4
5
6
7
8
9
10
GLOBAL
LOCAL

~33%
Globally
defined
~33%
Nationally
defined
~33%
Locally
defined
Source: Lowell Bryan, Jane Fraser, Jeremy Oppenheim and
Wilhelm Rall, Race for the World (Boston: Harvard Business
School Press, 1999), 45.
Some areas to consider when determining whether or not a
company has scale
advantages include:
• Distribution. Does the firm have local, regional, or national
distribution scale?
We would note that very few firms have national distribution
scale. Most
businesses have, at best, regional distribution advantages. One
good example

is retail. Wal-Mart (WMT, $51.38, Outperform, $65.00) built its
business in the
1970s and 1980s through regional distribution advantages. Most
retailers have
only regional advantages, and often fail to generate economic
profitability
outside their core markets.
One useful way to assess distribution strength is to look at the
firm’s operations
and revenues on a map. Firms likely have some advantages
where assets and
revenue are clustered.
• Purchasing. Some firms can purchase raw materials at lower
prices as the
result of scale. For instance, Home Depot (HD, $27.29,
Outperform, $40.00)
was able to tack over 200 basis points on to its gross margins in
the late 1990s.
The company attributed its margin expansion to a lower cost of
merchandising
resulting from product line reviews and increased sales of
imported products. In

32
other words, Home Depot used its size to get the best possible
price from its
suppliers. Increasingly, large firms are lowering their supplier’s
opportunity cost
by providing the supplier with better information about demand.
• Research and development. Economies of scope, related to
economies of
scale, exist when a company lowers its unit costs as it pursues a
variety of
activities. A significant example is research-and-development
spillovers, in
which the ideas that arise in one research project transfer to
other projects.
Companies that increase the diversification of their research
portfolios can often
find applications for their ideas better than they could when
their research
portfolios were smaller.
30
• Advertising. The advertising cost per consumer for a product
is a function of the
cost per consumer of sending the message and the reach. If the

fixed costs in
advertising (e.g., ad preparation, negotiating with the
broadcaster) are roughly
the same for small and large companies, the larger company will
have a cost
per potential consumer advantage because it can spread its costs
over a much
larger base.
Even if two companies can advertise on a national scale, the
larger one has an
advantage. Say both McDonald’s (MCD, $17.40, Neutral,
$21.00) and Wendy’s
(WEN, $28.18, Outperform, $40.00) have equally effective
national advertising
campaigns. That McDonald’s has many more stores than
Wendy’s lowers
McDonald’s per store advertising cost, giving it an advantage.
If you suspect a firm has production advantages, carefully think
through why its costs
are relatively lower than its competitors. Also, practical
experience suggests that firms
with production advantages often have lower gross margins than
companies with

consumer advantages.
Consumer advantage is the second broad source of added-value.
Firms with consumer
advantages also create value by delivering products that have a
larger spread between
perceived consumer benefit and cost than its competitors, but it
does that primarily by
outperforming competitors on the benefit side.
Here are some characteristic features of companies with
consumer advantages:
31
• Habit and high horizontal differentiation. A product is
horizontally differentiated
when some consumers prefer it to competing products. This
source of
advantage is particularly significant if consumers use the
product habitually. The
product need not be unambiguously better than competing
products, it just has
features that some consumers find attractive, and other
consumers may not.
Soft drinks are an example. Competing with Coca-Cola is hard
because many
consumers habitually drink Coke and are fiercely attached to the

product.
32
• Experience goods. An experience good is a product that
consumers can assess
only when they’ve tried it. Search goods, in contrast, are
products that a
consumer can easily assess at the time of purchase (e.g., hockey
pucks or
office furniture). With experience goods, a company can enjoy
differentiation
based on image, reputation, or credibility. Experience goods are
often
technologically complex.
• High switching costs (lock-in). Customers must bear costs
when they switch
from one information system to another. The magnitude of
switching costs
33
determines the degree to which a customer is locked in.
Sometimes switching
costs are large and obvious (e.g., $100 million for a company to

replace its
network) and sometimes they’re small but significant (e.g.,
$100 per customer
for 1 million customers to switch insurance providers). Exhibit
22 provides a
breakdown of various forms of lock-in and their associated
switching costs.
Exhibit 22: Types of Lock-In and Associated Switching Costs
Type of Lock-In Switching Costs
Contractual commitments
Durable purchases
Brand-specific training
Information and databases
Specialized suppliers
Search costs
Loyalty programs
Compensatory or liquidated damages
Replacement of equipment; tends to decline
as the durable ages
Learning a new system, both direct costs and

lost productivity; tends to rise over time
Converting data to new format; tends to rise
over time as collection grows
Funding of new supplier; may rise over time
if capabilities are hard to find/maintain
Combined buyer and seller search costs;
includes learning about quality of alternatives
Any lost benefits from incumbent supplier,
plus possible need to rebuild cumulative use
Type of Lock-In Switching Costs
Contractual commitments
Durable purchases
Brand-specific training
Information and databases
Specialized suppliers
Search costs
Loyalty programs
Compensatory or liquidated damages

Replacement of equipment; tends to decline
as the durable ages
Learning a new system, both direct costs and
lost productivity; tends to rise over time
Converting data to new format; tends to rise
over time as collection grows
Funding of new supplier; may rise over time
if capabilities are hard to find/maintain
Combined buyer and seller search costs;
includes learning about quality of alternatives
Any lost benefits from incumbent supplier,
plus possible need to rebuild cumulative use
Source: Carl Shapiro and Hal R. Varian, Information Rules
(Boston: Harvard Business School Press, 1999),
117.
• Network effects. Network effects can be an important source
of consumer
advantage, especially in information-based businesses. You can
think of two
types of generic networks (Exhibit 23). The first is a hub-and-

spoke network,
where the hub feeds the nodes. Examples include most airlines
and retailers. In
these networks, network effects are muted.
34
Exhibit 23: Network Effects Are Stronger in Interactive Than in
Radial Networks
Radial InteractiveRadialRadial InteractiveInteractive
Source: CSFB.
The second type is an interactive network, where the nodes are
connected to
one another—either physically (like telephone wires) or
virtually (like the same
software). Network effects tend to be significant for interactive
networks,
because as more people use the good or service, it becomes
more useful.
A key idea behind interactive networks is positive feedback. If
more than one

interactive network is competing for customers, the network
that pulls ahead will
tend to benefit from positive feedback, leading to a winner-
take-most outcome.
So the dominant network not only gets the most users
(contributing to scale
benefits), but also switching costs for those customers rise as
the network
becomes more and more significant. The canonical example of
this de facto
standard setting is Microsoft’s PC operating system business.
The pattern of cumulative users of an interactive network
follows an S-curve,
similar to the diffusion of other innovations. However, the S-
curve tends to be
steeper for interactive networks.
33
Everett Rogers found that the plot of new
adopters to a technology or network—really a derivative of the
S-curve—follows
a normal distribution. Technology strategist Geoff Moore used
this familiar
pattern as the basis of technology strategy and investing.
34

Judging the source and longevity of a company’s added value is
central to
understanding the likelihood of sustainable value creation.
Experience suggests that
consumer advantages often show up on the income statement as
high gross margins.
Exhibit 24 summarizes various functional areas and what
strategies to assess when
looking for producer or consumer advantages.
35
35
Exhibit 24: Sources of Added-Value and Functional Area
Strategies
Functional Areas Production Advantage Consumer Advantage
Source of Added Value
Product and Marketing
Strategies

- Standardized products
- Narrow price-cost margins with
prices lower than competition
- Little or modest product
promotion or advertising
- Modest postsale servicing or
maintenance
-Customized products
-Wide price-cost margins, with
prices higher than competition
-Emphasis on building products,
image through branding,
advertising, and product
promotion
-Extensive postsale service/
maintenance
-Generous warranties
Production Operations

Strategies
-Large mass-production facilities
to exploit economies of scale
-Capacity added behind demand
to ensure full utilization
-Products made to inventory, with
tight controls on inventory levels
- Willingness to sacrifice scale in
favor of customization and
flexible response to
unpredictable customer demand
- Capacity added in anticipation of
demand to ensure product
availability and minimize
chances of stockouts
- Products made to order
Engineering and Design -Products designed for
manufacturability

- Products designed to create
benefits for customers or lower
their costs
Research and Development Strategies -R&D emphasizes process
innovations, rather than new
products or basic research
- R&D emphasized product
innovations and basic research
more than process
Human Resources/
Organizations and Control
Strategies
-“Traditional” managerial style,
characterized by formal
procedure and rigid hierarchy
-Tough bargaining posture with
workers
-Tight administrative systems

emphasizing cost control
- Less formal managerial style,
fewer formal procedures, less
rigid hierarchy to promote
innovation and entrepreneurship
Functional Areas Production Advantage Consumer Advantage
Source of Added Value
Product and Marketing
Strategies
- Standardized products
- Narrow price-cost margins with
prices lower than competition
- Little or modest product
promotion or advertising
- Modest postsale servicing or
maintenance
-Customized products
-Wide price-cost margins, with

prices higher than competition
-Emphasis on building products,
image through branding,
advertising, and product
promotion
-Extensive postsale service/
maintenance
-Generous warranties
Production Operations
Strategies
-Large mass-production facilities
to exploit economies of scale
-Capacity added behind demand
to ensure full utilization
-Products made to inventory, with
tight controls on inventory levels
- Willingness to sacrifice scale in
favor of customization and

flexible response to
unpredictable customer demand
- Capacity added in anticipation of
demand to ensure product
availability and minimize
chances of stockouts
- Products made to order
Engineering and Design -Products designed for
manufacturability
- Products designed to create
benefits for customers or lower
their costs
Research and Development Strategies -R&D emphasizes process
innovations, rather than new
products or basic research
- R&D emphasized product
innovations and basic research
more than process

Human Resources/
Organizations and Control
Strategies
-“Traditional” managerial style,
characterized by formal
procedure and rigid hierarchy
-Tough bargaining posture with
workers
-Tight administrative systems
emphasizing cost control
- Less formal managerial style,
fewer formal procedures, less
rigid hierarchy to promote
innovation and entrepreneurship
Source: David Besanko, David Dranove, and Mark Shanley,
Economics of Strategy–2
nd
Ed. (New York: John Wiley & Sons, 2000), 420.
The final source of added value is external, or government-

related. Issues here include
subsidies, tariffs, quotas, and both competitive and
environmental regulation. Changes
in government policies can have a meaningful impact on added
value. Consider the
impact of deregulation on the airline and trucking industries,
emission standards for
diesel engines, and steel tariffs.
Firm Interaction—Competition and Cooperation
How a firm interacts with other firms plays an important role in
shaping sustainable
value creation. Here we not only consider how companies
interact with their
competitors, but also how companies can co-evolve.
36
Game theory is one of the best tools to understand interaction.
Game theory forces
managers to put themselves in the shoes of other players rather
than viewing games
solely from their own perspective.

The classic two-player example of game theory is the prisoner’s
dilemma.
36
We can
recast the prisoner’s dilemma in a business context by
considering a simple case of
capacity addition. Say two competitors, A and B, are
considering adding capacity. If
competitor A adds capacity and B doesn’t, A gets an outsized
payoff. Likewise, if B adds
capacity and A doesn’t, B gets the large payoff. If neither
expands, A and B aren’t as
well-off as if one alone had added capacity. But if both add
capacity, they’re worse-off of
than if they had done nothing. Exhibit 25 shows the payoffs for
the various scenarios.
Exhibit 25: Capacity and the Prisoner’s Dilemma
A
B
A
B
A

B
A
B
35
35
25
40
40
25
30
30
Competitor B
C
o
m
p
e
ti
to
r

A
Don’t Expand Add Capacity
D
o
n
’t
E
x
p
a
n
d
A
d
d
C
a
p
a
c
it
y
A
B
A
B

A
B
A
B
35
35
25
40
40
25
30
30
A
B
A
B
A
B

A
B
35
35
25
40
40
25
30
30
Competitor B
C
o
m
p
e
ti
to
r
A
Don’t Expand Add Capacity

D
o
n
’t
E
x
p
a
n
d
A
d
d
C
a
p
a
c
it
y
Source: CSFB.
Pankaj Ghemawat provides a more sophisticated example from a
major pharmaceutical
company’s actual pricing study.
37
Here, a challenger is readying to launch a substitute

for one of the incumbent’s most profitable products. The
incumbent’s challenge is to
determine the pricing strategy that maximizes the value of it’s
established product.
Exhibit 26 shows the payoffs given various assumptions. This
analysis allowed the
incumbent’s management to view the situation from the
challenger’s perspective, versus
considering only what it hoped the challenger would do.
37
Exhibit 26: The Payoff Matrix in the Face of a Challenger
Product Launch
Incumbent (I’s)
Price
Challenger (C’s) Price
Very Low Low Moderate High
No price
change

C has large
price advantage
C has small
price advantage
I neutralizes
C’s advantage
350/190 507/168 585/129 624/116
507/168418/163
454/155 511/138 636/126
428/50 504/124 585/129 669/128
Incumbent (I’s)
Price
Challenger (C’s) Price
Very Low Low Moderate High
No price
change
C has large
price advantage

C has small
price advantage
I neutralizes
C’s advantage
350/190 507/168 585/129 624/116
507/168418/163
454/155 511/138 636/126
428/50 504/124 585/129 669/128
Source: Pankaj Ghemawat, Strategy and the Business Landscape
(Upper Saddle River, NJ: Prentice-Hall,
Inc., 2001), 77.
In our simple capacity and product launch cases, we treated
competitor interaction as if
it were a onetime event. In reality, companies interact with one
another all the time. So
we can enhance our perspective by considering repeated games.
Social scientist Robert Axelrod ran a tournament to see which
strategy was most
successful in an iterated prisoner’s dilemma.
38
The winner was tit for tat. Tit for tat starts

by cooperating, but then mimics its competitor’s last move. So
if a competitor cuts price,
a company employing tit for tat would cut price as well. If the
competitor then raises
prices, tit for tat immediately follows. In practice, tit for tat is
effective only if companies
can judge clearly the intentions of their competitors.
We have found game theory particularly useful in considering
pricing strategies and
capacity additions.
39
A thorough review of a firm’s pricing actions and capacity
shifts, as
well as for the industry, can provide important perspective on
rivalry and rationality. The
institutional memory, especially for cyclical businesses, appears
too short to recognize
circumstances in which aiming for cooperation is the most
profitable strategy.
The way to go beyond the payoff matrix that considers only
onetime interaction is to
build a tree based on sequential actions. The approach here is
similar to strategy in

chess: look ahead and reason back.
40
Exhibit 27 is an example of a game tree developed by Sharon
Oster. Firm 1 is
considering whether to continue only with its first product or to
add a second product. In
either case, Firm 2 can respond with its own product move. The
payoffs at the end of
the tree show the economic consequences of the various
scenarios. In reality, such
analysis can be tricky because the range of alternatives is large.
But these game trees
can provide important perspective on competitive interaction,
and hence the prospects
for sustainable value creation.
38
Exhibit 27: Mapping Sequential Moves
Firm
1

Firm
2
Old
Old
and
New
Old
Old
and
New
Firm
2
Old
Old
and
New
O
1

O
2
O
3
O
4
Firm 1 $100
Firm 2 $100
Firm 1 -$30
Firm 2 +$250
Firm 2 -$30
Firm 1 +$250
Firm 1 $0
Firm 2 $0
Firm
1
Firm
2
Old
Old

and
New
Old
Old
and
New
Firm
2
Old
Old
and
New
O
1
O
2
O
3
O
4

Firm 1 $100
Firm 2 $100
Firm 1 -$30
Firm 2 +$250
Firm 2 -$30
Firm 1 +$250
Firm 1 $0
Firm 2 $0
Source: Sharon M. Oster, Modern Competitive Analysis
(Oxford: Oxford University Press, 1999), 252.
Our discussion so far has focused on competition. But
thoughtful strategic analysis also
recognizes the role of co-evolution, or cooperation, in business.
Not all business
relationships are conflictual. Sometimes companies outside the
purview of a firm’s
competitive set can heavily influence its value creation
prospects.
Consider the example of DVD makers (software) and DVD
player makers (hardware).

These companies do not compete with one another. But the
more DVD titles that are
available, the more attractive it will be for a consumer to buy a
DVD player and vice
versa. Another example is the Wintel standard—added features
on Microsoft’s operating
system required more powerful Intel microprocessors, and more
powerful
microprocessors could support updated operating systems.
Complementors make the
added value pie bigger. Competitors fight over a fixed pie.
39
What about Brands?
When queried about sustainable competitive advantage, many
executives and investors
cite the importance of brands. How significant are brands?
We can start with an empirical observation: Of the companies
that own the top fifteen
most valuable brands, as measured by brand consultant
Interbrand, four do not earn

their cost of capital.
41
(See Exhibit 28.) So a brand is clearly not sufficient to ensure
that
a company earns economic profits, much less sustainable
economic profits.
Exhibit 28: Brand Popularity Does Not Translate into Value
Creation
-10
-5
0
5
10
15
20
25
C
O
C
A
-

C
O
L
A
M
IC
R
O
S
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F
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IN
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'S
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B
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C
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C
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
25
Rank
R
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tu
rn
s

m
in
u
s
O
p
p
o
rt
u
n
it
y
C
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t
Source: Interbrand, CSFB HOLT.
We believe the best way to approach brands is to think through
the added-value lens.
Does the brand increase willingness to pay? The answer is
affirmative if the brand
confers horizontal differentiation. So your willingness to pay
might be higher for a brand

if you’re in the habit of using that product (Coke versus Pepsi,
or Pepsi versus Coke),
have an emotional connection to it, trust the product, or believe
the product brings you
social status.
Less likely, brands may reduce supplier opportunity cost. A
fledgling supplier often tries
to land a prestigious company, even at a discounted price, as
part of its effort to
establish credibility. To the degree that brand plays a role in the
perception of prestige
or credibility, it can reduce supplier opportunity cost, and hence
increase added value
for the branded company.
Exhibit 29 shows that brand itself is not a source of competitive
advantage. The exhibit
examines the total shareholder returns versus the S&P 500 for
the stewards of three top
brands, Disney (DIS, $16.87, Outperform, $24.00), Gillette (G,
$29.92, Not Rated), and
Coca-Cola. Each panel shows a similar pattern: a period of
significant share price
underperformance followed by a change in strategy and a period

of sustained
outperformance. In every case, the brand was well known before
and after the company
performed well. The brand is the not the key to competitive
advantage; the key is how
the company uses the brand to generate added value.
40
Exhibit 29: Brand Alone Does Not Create Value
W a lt D is n e y
0.00
50.00
100.00
150.00
200.00
250.00
300.00

1
/5
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9
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1
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150.00
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250.00
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350.00
400.00
1
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7
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C oca-C ola
0.00

50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
1
/5
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3
1
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5
1
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1
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1
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In
d
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h
a
r
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h
o
ld
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e
tu

r
n
s
Michael Eisner
became CEO in
September, 1984
Roberto Goizueta became
CEO in March, 1981
Several hostile
takeover attempts
(1986-1988)
W a lt D is n e y
0.00
50.00
100.00
150.00
200.00
250.00
300.00

r
n
s
Michael Eisner
became CEO in
September, 1984
Roberto Goizueta became
CEO in March, 1981
Several hostile
takeover attempts
(1986-1988)
Source: Datastream.
41
What about Management Skill?
Without a doubt, management skill is essential to understanding
sustainable value

creation. Management skill entails both fashioning the
strategy—the subject of this
analysis—and execution of the strategy. While execution is
critical, a detailed treatment
of the subject lies beyond the scope of this report.
One classic example of the importance of execution is Home
Depot. In an effort to
secure financing in its early days, Home Depot provided an
executive from a foreign-
based firm with access to the company’s early plans, including
store blueprints and
expansion intentions. After the parent company decided against
an investment in Home
Depot, the executive turned around and started a copycat
business in states where
Home Depot hadn’t yet expanded. The business floundered even
with all of Home
Depot’s numbers and business plans. Home Depot eventually
acquired the failing
competitor.
42
The core of execution is in three processes—the people process,
the strategy process,

and the operations process. Executives must chose and promote
people in light of the
strategic and operational realities. Strategy must take into
account the company’s ability
to execute it. And managers need to link operations to strategic
goals and human
capacity.
43
Large companies have a particular challenge because of the
significant complexity of
managing a large employee base. Companies must find
organizational structures that
allow them sufficient flexibility in a fast-changing world.
Another important related topic is management incentives.
Sustainable value creation
requires a constant balancing act between delivering current
results and allocating the
appropriate resources to assure a vibrant and value-creating
business in the future.
Incentives can play a central role in shaping this tenuous
balance.

42
Bringing It All Back Together
Stock prices reflect expectations for future financial
performance. Accordingly, an
investor’s task is to anticipate revisions in those expectations. A
firm grasp on the
prospects for value creation is a critical facet of this analysis.
But value creation itself is
no assurance of superior stock price performance if the market
fully anticipates that
value creation.
The expectations investing process has three parts:
44
1. Estimate price-implied expectations. We first read the
expectations embedded
in a stock with a long-term discounted cash flow model. We use
a DCF model
because it mirrors the way the market prices stocks.
2. Identify expectations opportunities. Once we understand
expectations, we apply

the appropriate strategic and financial tools to determine where
and when
revisions are likely to occur. A proper expectations analysis
reveals whether a
stock price is most sensitive to revisions in a company’s sales,
operating costs,
or investment need, so that investors can focus on the revisions
that matter
most. The strategic analysis in this report is the heart of
security analysis, and
provides the surest means to anticipate expectations revisions.
3. Buy, sell, or hold. Using expected-value analysis, we are now
in a position to
make informed buy, sell, or hold decisions.
A thorough analysis of a company’s prospects for sustainable
value creation is
essential. This analysis can then intelligently inform a financial
model, to determine
whether or not a particular stock offers prospects for superior
returns.

43
Appendix A: Value-Creation Checklist
What stage of the competitive life cycle is the company in?
Is the company currently earning a return above its cost of
capital?
What is the trend in return on capital—are returns increasing,
decreasing, or stable?
What is the trend in the company's investment spending?
Lay of the Land
What percentage of the industry does each player represent?
What is each player's level of profitability?
What have the historical trends in market share been?
How stable is the industry?
How stable is market share?
What have pricing trends looked like?
What class does the industry fall into—fragmented, emerging,
mature, declining,
international, network, or hypercompetitive?
Five Forces
How much leverage do suppliers have?
Can companies pass supplier increases to customers?
Are there substitute products available?
Are there switching costs?
How much leverage do buyers have?
How informed are the buyers?
Barriers to Entry

What are the entry and exit rates like in the industry?
What are the anticipated reactions of incumbents to new
entrants?
What is the reputation of incumbents?
What is the level of asset specificity?
What is the minimum efficient production scale?
Is there excess capacity in the industry?
Is there a way to differentiate the product?
What is the anticipated payoff for a new entrant?
Do incumbents have precommitment contracts?
Do incumbents have licenses or patents?
Are there learning curve benefits in the industry?
Rivalry
Is there pricing coordination?
What is the industry concentration?
What is the size distribution of firms?
How similar are the firms (incentives, corporate philosophy,
ownership structure)?
Is there demand variability?
Are there high fixed costs?
Is the industry growing?
Disruption/Disintegration
Is the industry vulnerable to disruptive technology?
Do new technologies foster product improvements?
Is the technology progressing faster than the market's needs?
Have established players passed the performance threshold?
Is the industry organized vertically, or has there been a shift to
horizontal
markets?

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